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The Ideal Financial Plan (Part 2 of 3)

The Ideal Financial Plan (Part 2 of 3)

January 22, 2022

The Ideal Financial Plan, Part 2: Saving for Your Goals

(Read: The Ideal Financial Plan, Part 1)

Once the protection module of the plan is in place, we have a solid foundation on which to build your wealth. The key principles that drive success in this module are to live deliberately, save and invest efficiently with your resources, and diversify the employment of your assets.

  1. Living Deliberately: Living deliberately refers to not just letting our lives happen. Living deliberately includes defining our core accumulation goals—short-term, mid-term, and long-term—and then putting together a saving plan to meet those goals. This includes not only building wealth but also defining a plan for “Toys and Fun” to ensure we make awesome memories along the way with the people that matter most in our lives. The better we plan for these goals and events the more we enjoy these events when they arise, rather than scrambling to figure out how to handle them at the moment.
  2. Efficiency: Living efficiently includes employing tax strategies and financial vehicles to reduce current and future taxes. It also includes limiting unnecessary fees and optimizing the amount of risk required for the returns on our investments. Lastly, efficiency means using one dollar to do the work of three dollars through the strategic use of our investments.
  3. Diversification: Also referred to as “asset allocation”, is an important part of growing the value of investments for different goals. Diversification refers to spreading money across different types of investments, or asset classes, to reduce risk exposure. Studies have shown that over 90% of volatility, or risk, in a portfolio can be attributed to how the money is split out amongst different types of asset classes. If we adjust the ratios among the asset classes we can raise or lower the volatility, or risk[1] in a portfolio, so it is important to know what your risk profile is.

Many investment advisors design their portfolios by either chasing returns of last year’s winners or by an assumed risk tolerance based on the age of investors. In reality, there are 80-year old’s with a risk tolerance of a 20-year old and 20-year old’s with a risk tolerance of an 80-year old. It simply varies from person to person and each investment portfolio should be tailored to each person. Keep in mind that though diversification is an approach to help manage investment risk, it does not completely eliminate market risk.

As your asset base grows it may make sense to further diversify into more speculative investments, which carry even higher growth potential. These investments can seem more exciting than more traditional investments; however, they also historically carry higher volatility and loss potential than more traditional portfolios. It is important to understand that a successful investment portfolio is not dependent on moving into these types of investments, but it may make sense to include them at some point in your planning, based on your interest level and overall position. 

Another important aspect of diversification is that as important as it is to diversify across different asset classes, it is also important to diversify how you are taxed with your investments. An ideal financial plan creates a plan to reduce taxes both now and in the future. I often recommend deferring taxes while people are in their highest earning years by utilizing a company 401(k) or IRA. The negative side of that is 100% of that money will be taxable as ordinary income once they start living off the money in those accounts. However, if you look at figure 1, those that have built up tax-free assets growing at the same time have created another option that could reduce the amount of money needed to pull from the now fully taxable retirement accounts. So, one strategy would be to pull just enough money to remain under the 12% tax bracket threshold and then supplement that money with non-taxable dollars to get to the standard of living you are looking for. In the example below, using today’s tax rates, you would pull $78,000 from your IRAs, which would be taxed at 12% and then pull an additional $42,000 from your tax-free bucket, to make up the remainder of your retirement income goal of $120,000 (in today’s dollars).

Remember, the important thing isn’t just how much wealth you accumulate … it’s how much wealth you keep. Some accounts are fully taxed all throughout the accumulation period, others can be invested before taxes are taken from them then grow tax-deferred, while others are invested with after-tax dollars, but grow tax-free. There are still others that are funded with after-tax dollars, but grow tax-deferred until the money is pulled out. By diversifying the way your wealth creation dollars are taxed you can reduce the overall taxation of money distributed from these accounts when you start spending them down.

"Portfolio Selection,” Barry Markowitz, Journal of Finance, Vol. 7, No. 1. (Mar. 1952), pp. 77-91; Thomas M. Idzorek, “Asset Allocation is King,” Morningstar Advisor (April/May 2010): 28–31